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Understanding Private Equity: Why More Investors are Including this Intriguing Asset Class in Their Portfolios

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Announcer: [00:00:00] Bringing you information and strategies used by the most affluent segment of society to help you create a financially optimized life of opportunity and fulfillment for you, your family, and the causes you care about with Secrets of the Super Rich. And now from his office in Scottsdale, Arizona, the founder and CEO of VFO Advisory Group, and your host, Vince Annable.


Vince Annable (Host): [00:00:24] Welcome, everybody, to Secrets of the Super Rich. Some people wonder why we would name a podcast, Secrets of the Super Rich. It’s because we’re going to reveal some of their secrets because most of you would like to know what it is they’re doing so you can do the same thing. And times have changed a lot. There are a lot of opportunities that the super rich have had in the past. We haven’t. And we’re going to talk about one of those, particularly today, which is why we named this particular podcast, why we need to understand the private equity markets, because it’s one of the most important asset classes you can include in your portfolio, probably offering some of the most intriguing returns and also a way to lower the volatility. You’ve all heard about volatility. I’m sure everybody’s been watching what’s going on and today is going to be very timely. So let me introduce our special guest today. Bob Long. Bob is the CEO of Conversus, which is part of the StepStone Group, which if you are not familiar with that name, they have a little over 500 billion (that was with a “B”) dollars in assets that they oversee and manage. And they only have 121 clients, for crying out loud. So you can do the math. Their investors entrust these guys with a lot of money. He has been named one of the top 50 game changers in the private equity investments world, profiled in the Wall Street Journal hosted CNBC Squawk Box in Europe on several occasions. Founding member of the Defined Contribution Alternatives Association chairs it’s Public Policy Committee. Bob Long, I’m excited to have you on today. I’m very excited about what you’re doing with your management company. We are utilizing what you guys are doing. We’re excited about it. And today what we want to do is provide some of those secrets that the super rich are able to access and you’re able to provide for them and now provide for minions like myself. So welcome to the show, Bob.


Bob Long (Guest): [00:02:49] Yes. Thank you for having me. Excited to have this opportunity to talk to you and share some of what we’ve learned about the private markets.


Vince Annable (Host): [00:02:56] Great. You’ve got many, many years of private market, private markets investing. What has been the biggest change you’ve seen in your 30 plus years in this area?


Bob Long (Guest): [00:03:13] When I started in this business, it was really in the formation phase or the inception phase. Some call it the cowboy phase, where funds vary dramatically in their terms. Pools of capital are formed quickly in order to take advantage of individual opportunities. And what we’ve seen then, really starting in the early nineties, was an institutionalization, a standardization of the private equity asset class and the related private debt, private credit, infrastructure and real estate asset classes into into something that’s much more similar to the public markets in terms of the structure and consistency and regulation around it. And now what we’re seeing in this third phase is the democratization of the private markets, where private assets are now packaged in a way that make more sense for individual investors. So that’s that transition is the biggest change that I’ve seen over 30 some years.


Vince Annable (Host): [00:04:10] Well, I skipped my opening question just because I don’t seem to be reading well today. So I’m going to hop back to our very first question, which was you obviously have a very distinguished career. I am sure that what you have done with Conversus and why StepStone would want to be involved means you’ve been a fantastic leader. Could you go through and explain to us just exactly what are these private markets people hear about but sometimes don’t know?


Bob Long (Guest): [00:04:44] Happy to do that. Thank you for those compliments. The private markets are a broad category of assets. That are effectively all of the real economy that is not publicly traded. You often read private markets followed or preceded by opaque dark pools. Shadow money. Nothing could really be further from the truth in that regard. These assets are. The building blocks of the capitalist economies. They go from the founder, family owned business to the large technology companies that remain privately owned. It really spans all of that. And private markets are just a broad phrase for anything that’s not a publicly traded stock or bond. So much of what is financed in the world today is done in the private markets. And the market cap, if you will, of the private markets today is much larger than that of the public markets. And, of course, the reason we are talking about it today is historically individual investors and even smaller institutions or even higher net worth individuals had a difficulty accessing the asset class, which I’m sure we’ll get to in the course of this conversation.


Vince Annable (Host): [00:06:09] So. All right. Public holdings are what most investors have in their portfolio. They’ve got Microsoft, they’ve got Apple, they’ve got Uber, they’ve got all of that because two reasons they haven’t had an education on private typically and because the aforementioned are liquid, they’re easy to access, easy to get into. What’s the opportunity set for private holdings, considering 90% of the companies in the US today are private companies?


Bob Long (Guest): [00:06:40] Yeah, the opportunity set is quite large. And as you mentioned historically there been barriers to accessing those investments. I think the opportunity set. Here’s here’s how I think about it. Most of the world’s largest and most sophisticated investors going back, frankly, well beyond modern capital markets, going back to the families of Europe that classically invested when there was blood in the streets and built massive companies, took advantage of dislocation and also took a long term view with patient capital. The opportunity, I think, to better summarize, is to get paid for your patients and investment language, that is to get paid and illiquidity premium for being.


Vince Annable (Host): [00:07:27] A man.


Bob Long (Guest): [00:07:28] Your your money into something you can’t sell every day. And to be clear, that’s what the private markets generally offer. That is that that is the negative of the private markets is this you don’t have the ability to sell every day. But in return for that, what you want to do and need to do is to receive an illiquidity premium. So a premium in return which top tier private assets have historically delivered. And also diversification benefits to pick up on the comments you made early on as you introduced our segment here. Private assets when structured properly and when diversified can provide you diversified within themselves as the portfolio can provide you as an investor with some ballast against the wild swings in the public markets as they move around. And we’re currently experiencing that with some geopolitical conflict. We all experienced that during COVID that will there were more in the past. There’ll be more in the future. So private markets can provide you return premium and diversification benefits. And that’s why the large investors have historically allocated a meaningful portion of their portfolios. And not only a meaningful portion, but many studies have shown a growing portion of their assets to the private markets.


Vince Annable (Host): [00:08:48] Well, I think you probably know I know Michael does is aware of our platform is we’ve created this household endowment model for our clients and the whole idea behind it is capture that illiquidity premium, make sure you’re not on the same roller coaster everybody else is, and smooth out the ride and maximize the returns. I learned that from a very smart guy named David Swenson, rest his soul. So, Bob, tell us who has historically invested in private markets?


Bob Long (Guest): [00:09:23] It is the world’s largest and most sophisticated institutions. Notably, the headline investors include the endowments of some of the most prestigious colleges in the country. You mentioned David Swenson, who ran the Yale Endowment. Harvard’s endowment. Stanford’s endowment have historically been significant investors. It’s been people who are investors who took a long term view, hired staff or else consultants like our parent company Step Stone, in order to understand these markets, understand these assets and make thoughtful decisions to create diversified portfolios of private assets to match up with their public assets and create the risk reward profile that seeks or that fits their needs, I’m sure, consistent with the household endowment model that you described. My experience and I’m not a financial advisor, but my observations, I packaged and created products for individual investors now for a significant period of my career is people really value–in fact, they typically overvalue liquidity. It’s most people of a certain wealth, and not all of us are in that position, love the idea that they could sell everything today. But in March of 2020, when the world was going to heck, they didn’t.  They didn’t when Russia attacked Ukraine. And most people, most investors do never intend to totally sell everything they have. And so you’re leaving money on the table, in my opinion. If you don’t put some of your capital to work in something where you get paid for that patience, you get paid for that risk tolerance and that willingness to ride through periods of uncertainty. What history has shown is uncertainty and dislocation are the friend of the private markets, and some of the best returns over time have been achieved by a diversified portfolio of private market assets that stays invested, and, in fact, often consistently adds to investments, adds to its allocation over periods of time, taking advantage of lower prices and higher return opportunities during periods of dislocation.


Vince Annable (Host): [00:11:49] Actually a way to protect the investors from themselves, because if they can’t liquidate, sometimes that’s the best thing that ever happens to them. And as I explain it to our clients, when an asset is illiquid, they can invest differently because they don’t have to sell it today or tomorrow. And it certainly is a valuable piece of any portfolio for not only gain larger gains, but also for stability. All right. So right now, we’re experiencing a threat of rising interest rates. We have inflation, we’ve got geopolitical war. We’ve got, obviously, Russia, Ukraine, cyber attacks, pandemics going on. What are the effects of all this volatility? And it is volatility out there as a result of all those things. And now it seems we’ve experienced it all at the same time. How does that affect the private markets versus the public markets?


Bob Long (Guest): [00:12:50] Well, the private markets do benefit from less volatility in asset pricing because unlike the public companies our assets are not priced every day. They’re generally priced every quarter. They’re not priced every day. We and the general partners in funds we work with and our portfolio and our we it Stepstone and broadly at Conversus, generally invest in multiple managers and multiple assets. We don’t have to sell them into a period of dislocation and so we certainly benefit from that. I think the other thing hearkens back to what I said earlier. There are opportunities created when there’s dislocation. There are people who need liquidity, institutions, investors who need liquidity, and private market investors are able to step up and provide liquidity when it’s in short supply and as you’d expect, get paid for that. So I think that’s the opportunity in any period of dislocation is to be a provider of liquidity. When your balance sheet can handle that and to receive an appropriate level of return for that, which often has been very attractive.


Vince Annable (Host): [00:13:59] So why have all but the biggest investors made only limited allocations into private markets? What’s keeping people out?


Bob Long (Guest): [00:14:09] It’s a really good question. Unfortunately, they are significant barriers for high net worth individuals in accessing the private markets. And those barriers are both they run they run a range of categories. First of all, there’s a regulatory barrier. In most cases, you have to be an accredited investor, $1,000,000 of net worth. And in many, many cases, you have to be a qualified purchaser of 5 million of net worth, so very few individuals. But now today you see a variety of products designed for the accredited investor. So first, there’s a qualification. Secondly, the Traditional Private Markets Fund is a limited partnership with what is called a drawdown structure, and this may be unfamiliar to many of our listeners. So when you buy a public stock, you invest $10,000, you buy X number of shares. Well, if you commit by the way, the minimums are generally very high. They’re often $1,000,000 and rarely under 250,000. When you commit to a private market fund, you typically commit. But you’re not invested. You commit. I’ll use the $250,000. You commit $250,000, and then that fund draws the capital down over time in a series of unpredictable capital calls to you on generally ten business days notice. Then they invest that into a series of companies. That investment period, it runs 3 to 5 years. Then they sell those over a harvesting period, call out another 3 to 5 years and get your capital back.


Bob Long (Guest): [00:15:53] So both are unpredictable. And essentially what they’re doing is outsourcing the cash management to you, the investor. So that in itself, and moreover, you’re not invested with your 250,000. In my example, you’re just committed. So if you’re trying to run a disciplined asset allocation model, which I suspect your your household endowment model focuses on, you don’t get there by committing. You need to be invested. So there’s a mismatch between that. Moreover, you’re generally paying fees on your committed amount, not your invested amount. This creates what’s called the J Curve in private and the private markets, particularly private equity. So there’s a big structural change. Moreover, these entities are partnerships from a tax perspective. So you receive the dreaded K-1. You receive it not in time to file your tax return by April 15th, you’re automatically kicked into filing an extension. And it’s a it’s a complicated document that that complicates your taxes as an individual. So high minimums, unpredictable cash flows, K-1 fees on capital that is invested, that is committed, not invested. So there’s a lot of reasons why only the highest high net worth individuals who already have tax advisors, legal advisors, a sophisticated financial advisor, have invested in the private markets. So lots of those reasons.


Vince Annable (Host): [00:17:31] And there’s been a lot of changes now over the last ten years that has simplified the access, which is what we’re looking for. I mean, the the the very wealthy out there, they have this club mentality. And at the club they’re all getting together, putting together these deals, and everybody else is left out. But today that’s all changed. There’s a whole new access point to be able to get into these opportunities. And also I think a lot of it falls on our industry and that the financial advisors themselves are not educated in how private markets work and they do not educate their clients because they’re unsure of what they’re talking about and they don’t feel comfortable talking about something they aren’t comfortable with, basically. So what’s the importance of diversification for a guy like me? I’m diversifying, building out this portfolio for the private markets and I look to teams like yours, you, Michael, etc. What’s the importance of diversification?


Bob Long (Guest): [00:18:44] You know, I’d love to answer that. Would you like me to go back and talk about the solutions to the problems I described earlier?


Vince Annable (Host): [00:18:54] That would be A-OK with me.


Bob Long (Guest): [00:18:56] All right. Let’s do that, too.


Vince Annable (Host): [00:18:58] So I think I stepped on you there, huh?


Bob Long (Guest): [00:19:00] Yeah, you did. You double down. Two questions. So, Vince. Um, about really about ten years ago, as you described, a new class of private market funds emerged that are typically registered with the SEC. So they have the benefit of that oversight and that public reporting. Lower minimums for investors, often about $50,000. Now they are limited to accredited investors, and the SEC has broadened that definition. but still, that is the law today. There’s there are moves afoot to further democratize and further broaden the playing field. But that’s that’s the law today. Accredited investors, they’re SEC registered. But more importantly, they are permanent capital vehicles that are evergreen vehicles. They look much more like a mutual fund. So with these funds, when you commit dollars, those dollars are immediately invested. The fee loads are generally lower. They are not a partnership. They are Corporation for Tax. So you get a 1099 just like you would from a mutual fund. You get it in January like you would from a mutual fund. And these phones report. Your value on a daily or monthly basis, so you can’t trade them every day. Today they generally have quarterly liquidity and there are some limits and constraints on that. More of a nuance that I could be happy to get into if you’d like. But these are evergreen vehicles that you can buy into on a daily or monthly basis with a value that’s daily or monthly.


Bob Long (Guest): [00:20:48] Your capital gets immediately invested. The fees are reasonable. They look pretty similar to what institutions pay. And unlike what we call the drawdown funds instead of outsourcing the cash management to you the investor, these funds take on and we obviously run one we take on the cash management for you and take responsibility to get your money invested for you and also to provide liquidity for you when you need it generally with 90 days notice. So these are these are hybrids. They sit between your daily traded exposure, the things you can sell every day and a drawdown fund that kind of described before the traditional limited partnership that typically have a 15-year life. I probably didn’t sufficiently emphasize that point when we talked about those. Those are 15 year life vehicles where your first cash flow to your last dollar coming back is generally about 15 years. So these funds that are in interval funds or tender funds, they go by a variety of names and they have their differences in the structures. That’s been the advancement that’s democratizing access for individual investors to the private markets, these structures that are designed really with the individual investor in mind and to make it more convenient, transparent, efficient for for those investors.


Vince Annable (Host): [00:22:15] Okay. What is the importance–we’ll go back–the importance of diversification and for a guy like me, creating this portfolio. And before you answer that, I’ll make a side note on your last answer. One of the also the keys to these private programs not outsourcing the cash management is typically you your team, your company is infusing capital and investing right alongside of all the investors. So want to point that out. Anyway, so how do we build this diversified portfolio in the private markets? How important is that?


Bob Long (Guest): [00:22:57] It’s extremely important. What all the studies show, I shouldn’t say oh, many of the studies show is that a diversified portfolio of private markets, it adds that balast to the portfolio. We talked about protecting you against wild swings in the public markets and also adds the return premium. But it needs to be diversified. In the public markets if you’re my financial advisor, and we decided I needed to invest some of my capital in a US large cap growth spot, well, you’d have some thoughtful advice and we’d pick a fund, but frankly, t he range of outcomes returns between a good fund and a great fund or a mediocre fund and a great fund is really narrow in the public markets. Really, really narrow. We could show some graphs. This presentation is probably not tactical enough for that. It’s really narrow. Like the difference between. 7%, 9% over a ten year period of time. If you look at the private markets, the difference between a first quartile fund and a best performer and a fourth quartile fund, the weakest performers, it can be 20% or more. So the range of outcomes is really, really wide, and that’s just a huge difference between the public markets and the private markets. So to make sure you get the return premium, you need to be in a diversified portfolio.


Bob Long (Guest): [00:24:28] We think that generally individual investors should have some private equity. They should also have infrastructure, real estate and some private debt. So there are a number of ways to get private debt. It’s hard to get infrastructure and real estate can be accessed in a number of ways, but we like the idea of private market investors being diversified amongst the asset classes. The other thing you need to be is diversified geographically. So the investment vehicle you choose, or vehicles, should provide exposure to the high growth emerging economies and also to establish economies in Asia and the established economies in Europe. So it’s important to be global and it’s important to be diversified by some strategy or stage. So to have some investments in small companies, along with the very large technology companies that have not yet gone public or may never, frankly, may never go public to have investments across stage sector, industry diversification probably should have mentioned that first, private market, particularly private equity, tends to be very tends to have more exposure to information technology and health care. So you want to make sure your portfolio also includes basic businesses, industrials, industrials, businesses, business services and that sort of thing. So your private markets portfolio needs to be diversified just like your public market portfolio in order to give you the return profile.


Vince Annable (Host): [00:25:59] All right, Bob. So we’re winding down in this podcast, which has been extremely valuable. A couple of very important points I want to help our listeners with, because people are going to listen to this and they’re going to go, “Yes, I’m very interested in private markets.” And then they’re going to go, “But how do I find somebody that knows about them? And how do I evaluate when somebody comes to me and shows me private markets investments? How do I evaluate that? And who should I rely on?”


Bob Long (Guest): [00:26:33] I think the most important characteristic of any investment is the management team and understanding the skills and experience and frankly the values and culture of the team you’re investing with. Part of that is often alignment of interest and the private markets, typically, management teams invest a meaningful amount of their own capital into the same transactions that you’re investing in. So you certainly should be paying attention to that. After management team. I think structure is very important. These structures are complex. There’s no getting around it. We’ve talked about some of the details and nuances of those. These. But while they’re complicated, they should be explainable. They should make sense to you. And they should be easy for you to use. They should be as similar to that, which is experienced by or purchased by the largest institutions as possible. And that’s a question you should ask. Tell me how this is different than what my college endowment is doing. How is it different than what my state pension plan, who are very large investors in private markets, are doing? Contrast and compare for me the product you’re suggesting versus what they experience. In that regard, there are three things we talk about a lot at our firm.


Bob Long (Guest): [00:27:52] And they are. Convenience. How easy is it? How easy can we make it for the individual investor to invest? Transparent. No surprises in the private markets. There are lots of moving parts, as we’ve touched on today. But nonetheless, you should expect and demand that the sponsor of that product, the manager, is completely transparent with you on what they are charging every dollar they’re getting paid, why and when and the basis of it. You should be very focused on that. And then lastly, efficient. That’s a nice way of saying cheap, but products can be cost effective for individual investors when they’re structured properly. And that goes with transparency. You should understand what is the manager getting paid? And how does that compare to what institutions would pay for a similar service and product? Those are the things that we think individuals should be focused on. It’s frankly not that different than what the largest institutions are focused on, with the exception that the institutions have huge teams of operational people and the convenience piece is not as important to them as it is for those of us individuals who are seeking to invest ourselves.


Vince Annable (Host): [00:29:13] Wow. So there’s 30 years of experience wrapped up into 30 minutes. That was pretty darn good. Bob, thank you. That was very educational. As you and Mike both know, we are very big on private markets. We are very big on utilizing these types of investments for our clients portfolios. So we appreciate you coming on today to explain. And, you know, the title of this podcast is Secrets of the Super Rich. So for you listeners, you just heard some secrets that were revealed on what the super rich are doing and why they do it from Bob Long. So thanks, Bob, very much for coming on today.


Bob Long (Guest): [00:29:59] Well, thank you. I think you’re doing a great service to investors by educating them on this asset class and the opportunity that lies there for them.


Vince Annable (Host): [00:30:08] Great. Thank you very much. So I hope everybody enjoyed the podcast today. I’m sure you did. If you didn’t, go ahead and email me and I’ll point out why you should have. Hopefully you learn something new today because that’s our goal. We want to provide you education. That’s the whole purpose of our podcast. We want to do what the superrich do and that’s accumulate, protect and preserve their wealth. If you like what you hear, there’s a button someplace on here. You get to go press and you can subscribe to our podcast to learn more about what we do with our virtual family offices and why that’s an important part of overall wealth management. You can go to vfoag.com. There’s a quick two-minute video. You can watch that. Yes, it’s done by me, but it’s only 2 minutes, so you’ll be okay and let me think. Is there anything I’m leaving out? I think after that, you’re oh, you will also have access to our white paper, which is on the virtual family office. And we would love to have you reach out if you would like just more education. We can spend some time together educating you on how and why we use private markets, because it’s the thing to do today and it’s one of the secrets of the super rich. So I’m Vince. Annabelle, thanks very much for listening and we’ll see you next time.


Announcer: [00:31:39] This program has been presented for the education of our listeners only and is not intended as investment advice, nor is it intended as a solicitation of investment products or services of any kind. We encourage you to seek the advice of a licensed professional financial advisor before making any investment decisions.